Further steps will be necessary and not just one spectacular event which solves everything, Merkel told reporters on Tuesday.

Widespread hopes for a single solution to make the Greek crisis disappear were unrealistic, she said, as officials wrestled with complex options for involving private bondholders in a second rescue of the debt-stricken euro zone state.

The euro eased against the dollar after the German leader said demands were too high for Thursday's talks, which are only part of an incremental series of steps to address Greece's debt and competitiveness problems.

The European currency area is facing the biggest crisis of its 12-year existence, with contagion threatening major economies such as Italy and Spain after three small members -- Greece, Ireland and Portugal -- needed bailouts.

In a sign of concerns about the potentially broad ramifications of the crisis, U.S. President Barack Obama spoke with Merkel on Tuesday.

They agreed that dealing effectively with this crisis is important for sustaining the economic recovery in Europe as well as for the global economy, the White House said in a statement.

French President Nicolas Sarkozy was to meet Merkel on Wednesday in Berlin to prepare for Thursday's summit, his office said.

The International Monetary Fund urged euro zone leaders to act swiftly to increase the size of their 440 billion euro rescue fund and allow it to buy debt on the secondary market, two issues that are unlikely to be settled this week.

It would be very costly not just for the euro zone but for the global economy to delay tackling the sovereign crisis, IMF official Luc Everaert said, presenting an IMF staff report.

We need more Europe, not less, he said.

A confidential euro zone paper drafted ahead of the 17-nation summit and obtained by Reuters showed a tax on banks and cheaper, longer-dated official loans would be the least risky way to provide extra funding for debt-stricken Greece.

With financial markets on edge two days before the crucial meeting, other options for private sector involvement that could trigger a selective or outright Greek default with far-reaching consequences remain on the table, the paper showed.

Banking sources said they expected leaders to agree on a range of possibilities for private bondholders to contribute, rather than a single option.

French European Affairs Minister Jean Leonetti confirmed late on Monday that euro zone officials were eyeing a bank tax to raise extra money to help Greece, which needs a further 115 billion euros in funding by mid-2014 on top of a 110 billion euro EU/IMF bailout agreed last year.

The French and German banking federations protested against the idea, saying it was the wrong approach to help Greece.

A source familiar with the talks said a small levy on banks could raise 10 billion euros a year, yielding the 30 billion euros over three years targeted by Germany, which has led the drive for private sector involvement in a new Greek program.

A tax would appear to have the drawback of lumping together banks that have an exposure to Greece and those that do not, but the source said it could be structured so that the main burden fell on those with Greek holdings. He did not say how.

OPTIONS

A banking source and a national government official said the inclusion of a tax proposal was aimed at pressuring banks and insurers into agreeing on an acceptable form of voluntary private sector involvement in supporting Greece.

Talks on this led by the International Institute of Finance (IIF), a banking lobby, were continuing in Rome on Tuesday.

'If you don't come up with anything we can live with, we will impose a tax', is the threat that is hanging over the talks. This makes the negotiations even more difficult, one banking source said.

Another banking source said the IIF-led talks would continue after Thursday and could turn into a forum for discussing an eventual restructuring of Greece's 350 billion euro debt -- nearly 160 percent of annual economic output.

The options paper, dated July 16 but which officials said still reflects the wide open state of debate, showed that a tax on the financial sector was the only proposal deemed unlikely to cause a selective default.

It suggested the levy could be combined with a commitment by Greek banks to roll over their big holdings of government debt, and an extension of the maturity and a further reduction of the interest rate on euro zone loans to Athens.

The document gave no figure but officials have said they are considering extending the loans to 30 years and cutting the interest rate to 3.5 percent from the original 5.5 percent, which was reduced to 4.5 percent in March.

A German newspaper reported on Tuesday that a panel of economic advisors to the government favored a haircut on Greek debt of around 50 percent in view of the worsening euro zone debt crisis.

The European Central Bank has insisted that any solution must avoid causing a credit event, which would trigger a payout of default insurance, or a full or selective default.

ECB President Jean-Claude Trichet warned again this week that the central bank would not accept Greek government bonds as collateral to obtain liquidity in such circumstances, forcing euro zone governments to rescue Greek banks.

Another ECB policymaker, Ewald Nowotny of Austria, appeared to offer a glint of flexibility, saying a solution could depend on the duration of a selective default. But his spokesman said later he stood by the central bank's official line.

There are some proposals that deal with a very short-lived selective default situation that would not really have major negative consequences, Nowotny told CNBC in an interview broadcast on Tuesday.

The euro zone paper said other options such as an EU-funded Greek government buy-back of its own debt on the secondary market, a German-proposed bond swap for longer maturities and a French plan for a voluntary rollover of maturing Greek debt would all generate additional costs for official lenders.

In those scenarios, euro zone governments would have to provide billions of euros to recapitalize Greek banks and provide them with collateral to obtain ECB funding, it showed.

A buy-back of Greek debt would do most to reduce Athens' debt mountain and make it more sustainable. But it would also be the most costly option for the public purse, requiring billions of euros in additional euro zone loans on top of support for Greek banks and ECB collateral, the paper showed.

Another EU source said the outcome of Thursday's meeting was likely to be a mix of several options, with a bank tax, some form of debt swap and substantial extra loans to Greece from the euro zone's EFSF rescue fund.

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